Starting a business involves more than choosing a name and finding customers. One of the most important early decisions is selecting the right legal and tax structure.
Common business structures in the United States include sole proprietorships, partnerships, limited liability companies (LLCs), and corporations. Each option can affect liability, taxation, ownership, financing, and ongoing compliance requirements.
A corporation can provide significant advantages, but it also comes with more formal requirements than many other business structures. Understanding how corporations work can help business owners determine whether this structure fits their goals.
What Is a Corporation?
A corporation is a legal business entity that is separate from its owners, who are generally called shareholders. The corporation can own property, enter contracts, hire employees, conduct business, incur debts, and pay taxes in its own name.
Corporations are generally governed through a board of directors and officers. Ownership is represented by shares of stock.
The exact process for creating a corporation depends on the state where the business is formed. Generally, the process involves preparing and filing formation documents with the appropriate state agency and establishing the corporation's internal governance documents.
Because forming a corporation involves both legal and tax considerations, business owners may benefit from working with an attorney and a qualified tax professional before choosing this structure.
Advantages of Forming a Corporation
Limited Liability Protection
One of the primary reasons businesses choose a corporate structure is the potential for liability protection. Because the corporation is legally separate from its shareholders, shareholders are generally not personally responsible for the corporation's debts and obligations.
However, limited liability is not absolute. Personal guarantees, certain legal violations, improper conduct, and other circumstances can create personal exposure.
Continuity of the Business
Corporations can generally continue operating even if an owner leaves, sells shares, or dies. This continuity can make the business easier to transfer and may be attractive to investors or potential buyers.
Easier Transfer of Ownership
Corporate ownership is represented by shares of stock. Depending on the corporation's governing documents and applicable laws, shares may be transferred from one owner to another.
S corporations, however, have restrictions on who can own shares and how their stock can be structured.
Potential Access to Investment Capital
The corporate structure can make it easier to bring in investors because ownership can be divided into shares. This can be particularly useful for businesses that expect to raise outside capital or eventually have a large number of owners.
Tax Planning Opportunities
Corporations can have different federal tax treatments depending on their classification and elections. A C corporation is generally taxed at the corporate level, while an eligible corporation can elect S corporation treatment so that income generally passes through to shareholders for federal income tax purposes.
Tax benefits should not be assumed simply because a business is incorporated. The appropriate structure depends on the company's income, ownership, compensation, distributions, state taxes, and other circumstances.
Potential Disadvantages of a Corporation
More Formal Requirements
Corporations generally have more administrative requirements than sole proprietorships and many LLCs. Depending on state law, corporations may need to maintain bylaws, conduct meetings, document corporate decisions, maintain records, issue stock, and meet annual reporting requirements.
Formation Costs
Creating a corporation normally involves state filing fees and other potential costs. Fees and requirements vary depending on the state.
Possible Double Taxation
A C corporation is generally a separate federal taxpayer. Its taxable income is taxed at the corporate level, and distributions of after-tax profits as dividends may also be taxable to shareholders. This is commonly referred to as double taxation.
S corporation taxation can provide pass-through treatment for qualifying businesses, although S corporations have specific eligibility and tax-compliance requirements.
Common Types of Corporations
C Corporation
A C corporation is the standard corporate tax classification for federal income tax purposes unless another election applies.
C corporations can generally have an unlimited number of shareholders and different classes of stock. They are commonly used by businesses that plan to attract investors or grow significantly.
S Corporation
An S corporation is generally a corporation—or an eligible entity that elects to be treated as a corporation—that makes an election for federal pass-through taxation.
The IRS requires an S corporation to meet several conditions, including having no more than 100 shareholders, having only allowable shareholders, having no nonresident alien shareholders, and generally having only one class of stock. The election is made using Form 2553.
Importantly, an LLC can also elect S corporation tax treatment if it meets the requirements. Forming an LLC and making an S corporation election is different from legally forming a corporation under state law.
Benefit Corporation
A benefit corporation is a state-law business structure available in many states that allows a for-profit company to pursue specified social or environmental objectives in addition to financial goals.
A benefit corporation should not be confused with a certified B Corporation. B Corp certification is a private certification, while benefit corporation status is created under applicable state law.
How to Form a Corporation
The exact procedure varies by state, but the process commonly includes the following steps.
1. Choose and Check Your Business Name
Select a corporate name that complies with your state's naming rules. Before filing, check whether the name is available and whether another business is already using a confusingly similar name.
2. Appoint Initial Directors
Corporations are generally governed by a board of directors. State law determines requirements concerning directors, including the number of directors and eligibility.
3. Prepare and File Articles of Incorporation
Articles of incorporation, sometimes called a certificate of incorporation or certificate of formation, establish the corporation under state law.
Depending on the state, the document may include information such as the corporation's name, purpose, registered agent, authorized shares, and information about incorporators or directors.
4. Establish Corporate Bylaws
Bylaws establish the corporation's internal operating and governance rules. They can address the responsibilities of directors, officers, and shareholders and explain how important corporate decisions are made.
5. Hold the Initial Organizational Meeting
After formation, the corporation may hold an initial meeting to approve bylaws, appoint officers, authorize stock issuance, and take other organizational actions. Corporate records and meeting minutes should be maintained carefully.
6. Issue Shares of Stock
The corporation should document the shares issued to each shareholder and maintain appropriate ownership records.
7. Obtain an EIN
Corporations generally need an Employer Identification Number (EIN). The IRS describes the EIN as the federal tax identification number used to identify a business.
The IRS provides EINs free of charge, and businesses forming a legal entity should generally register the entity with the state before applying for the EIN.
8. Obtain Required Licenses and Permits
Depending on the business activity and location, the corporation may need federal, state, county, or local licenses and permits. Requirements vary by industry and jurisdiction.
Is a Corporation Right for Your Business?
A corporation can be a strong choice for a business that wants formal ownership through shares, potential access to investors, continuity, and liability protection.
However, incorporation also creates additional administrative responsibilities and can have significant tax consequences. Choosing between a corporation, LLC, partnership, or another structure should be based on the business's ownership, expected income, financing plans, liability concerns, and tax situation.
Before forming or changing a business entity, consider consulting an attorney regarding legal and state-law requirements and a qualified tax professional regarding federal and state tax consequences.
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